Saturday, November 01, 2008

As dozens of countries slip deeper into financial distress, a new threat may be gathering force within the American economy — the prospect that goods will pile up waiting for buyers and prices will fall, suffocating fresh investment and worsening joblessness for months or even years.

The word for this is deflation, or declining prices, a term that gives economists chills.

Deflation accompanied the Depression of the 1930s. Persistently falling prices also were at the heart of Japan’s so-called lost decade after the catastrophic collapse of its real estate bubble at the end of the 1980s — a period in which some experts now find parallels to the American predicament.

“That certainly is the snapshot of the risk I see,” said Robert J. Barbera, chief economist at the research and trading firm ITG. “It is the crisis we face.”

With economies around the globe weakening, demand for oil, copper, grains and other commodities has diminished, bringing down prices of these raw materials. But prices have yet to decline noticeably for most goods and services, with one conspicuous exception — houses. Still, reduced demand is beginning to soften prices for a few products, like furniture and bedding, which are down slightly since the beginning of 2007, according to government data. Prices are also falling for some appliances, tools and hardware.

Only a few months ago, American policy makers were worried about the reverse problem — rising prices, or inflation — as then-soaring costs for oil and food filtered through the economy. In July, average prices were 5.6 percent higher than a year earlier — the fastest pace of inflation since 1991. But by the end of September, annual inflation had dipped to 4.9 percent and was widely expected to go lower.

The new worry is that in the worst case, the end of inflation may be the beginning of something malevolent: a long, slow retrenchment in which consumers and businesses worldwide lose the wherewithal to buy, sending prices down for many goods. Though still considered unlikely, that would prompt businesses to slow production and accelerate layoffs, taking more paychecks out of the economy and further weakening demand.

The NY Times article continues with the relationship between interest rates and inflation. Policy makers can "choke off inflation by raising interest rates," but that could further send the U.S. economy into a deeper recession, and reduce demand for goods. The example of Japan is brought up, as "an economy may remain ensnared by deflation for many years, even when interest rates are dropped to zero: falling prices make companies reluctant to invest even when credit is free." According to the New York Times:

Through much of the 1990s, prices for property and many goods kept falling in Japan. As layoffs increased and purchasing power declined, prices fell lower still, in a downward spiral of diminishing fortunes. Some fear the American economy could be sinking toward a similar fate, if a recession is deep and prolonged, as consumers lose spending power just as much of Europe, Asia and Latin America succumb to a slowdown.

“That’s a meaningful risk at this point,” said Nouriel Roubini, an economist at New York University’s Stern School of Business, who forecast the financial crisis well in advance and has been warning of deflation for months. “We could get into a vicious circle of deepening malaise.”

I'll admit that at first, I've been worried about an opposite effect of stagflation, which is rising inflation, coupled with slowing economic growth, or an economic recession. My reasoning for this has been the combination of the slowing U.S. economy and the rising energy and gas prices--with the rising energy prices sending prices on every other U.S. good to also go up in price. But with the Wall Street financial market meltdown, and the meltdown in the world financial markets, there is now a fear that the world economy may be going into a recession, and that demand for commodities--oil, gas, copper, steel, grains, and such, may be reduced, sending prices spiralling even lower. So far, the Federal Reserve has been pumping billions of dollars into the U.S. economy--through both the half-point cut in the interest rate and the $750 billion bailout package for Wall Street. Kenneth S. Rogoff, a former chief economist at the International Monetary Fund and now a professor at Harvard, states that “If you print enough money, you can create inflation,” thus countering the effects of deflation. At this point, I can't say whether the U.S. economy is heading into a deflationary period, and inflationary period, or stagflation. All I can say is that the U.S. economy is in serious trouble.